Modern Pricing Theory Based on Risk-Neutral Valuation

“A mathematical framework for assembling a portfolio of assets such that the expected return is
maximized for a given level of risk which formalizes and extends on investing diversification, where, the
idea that owning different kinds of financial assets is less risky than owning only one type”

Modern Portfolio Theory (MPT)

By 
JAMES CHEN
 
 
Reviewed by 
PETER WESTFALL
 
 
Updated Mar 1, 2021
What Is Modern Portfolio Theory (MPT)?
Modern portfolio theory (MPT) is a theory on how risk-averse investors can
construct portfolios to maximize expected return based on a given level of market
risk. Harry Markowitz pioneered this theory in his paper "Portfolio Selection,"
which was published in the Journal of Finance in 1952.1 He was later awarded a
Nobel Prize for his work on modern portfolio theory.2

KEY TAKEAWAYS

 Modern portfolio theory (MPT) is a theory on how risk-averse investors can

construct portfolios to maximize expected return based on a given level of
market risk.
 MPT can also be used to construct a portfolio that minimizes risk for a
given level of expected return.
 Modern portfolio theory is very useful for investors trying to construct
efficient portfolios using ETFs.
 Investors who are more concerned with downside risk than variance might
prefer post-modern portfolio theory (PMPT) to MPT.

Understanding Modern Portfolio Theory (MPT)

Modern portfolio theory argues that an investment's risk and return
characteristics should not be viewed alone, but should be evaluated by how the
investment affects the overall portfolio's risk and return. MPT shows that an
investor can construct a portfolio of multiple assets that will maximize returns for
a given level of risk. Likewise, given a desired level of expected return, an
investor can construct a portfolio with the lowest possible risk. Based on
statistical measures such as variance and correlation, an individual investment's
performance is less important than how it impacts the entire portfolio.3
MPT assumes that investors are risk-averse, meaning they prefer a less risky
portfolio to a riskier one for a given level of return. As a practical matter, risk
aversion implies that most people should invest in multiple asset classes.3
The expected return of the portfolio is calculated as a weighted sum of the
individual assets' returns. If a portfolio contained four equally weighted assets
with expected returns of 4, 6, 10, and 14%, the portfolio's expected return would
be:
(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%
The portfolio's risk is a complicated function of the variances of each asset and
the correlations of each pair of assets. To calculate the risk of a four-asset
portfolio, an investor needs each of the four assets' variances and six correlation
values, since there are six possible two-asset combinations with four assets.
Because of the asset correlations, the total portfolio risk, or standard deviation, is
lower than what would be calculated by a weighted sum.3

Benefits of Modern Portfolio Theory (MPT)

MPT is a useful tool for investors trying to build diversified portfolios. In fact, the
growth of exchange traded funds (ETFs) made MPT more relevant by giving
investors easier access to different asset classes. Stock investors can use MPT
to reduce risk by putting a small portion of their portfolios in government bond
ETFs. The variance of the portfolio will be significantly lower because
government bonds have a negative correlation with stocks. Adding a small
investment in Treasuries to a stock portfolio will not have a large impact on
expected returns because of this loss reducing effect.3

Similarly, MPT can be used to reduce the volatility of a U.S. Treasury portfolio by

putting 10% in a small-cap value index fund or ETF. Although small-cap value
stocks are far riskier than Treasuries on their own, they often do well during
periods of high inflation when bonds do poorly. As a result, the portfolio's overall
volatility is lower than one consisting entirely of government bonds. Furthermore,
the expected returns are higher.3
Modern portfolio theory allows investors to construct more efficient portfolios.
Every possible combination of assets that exists can be plotted on a graph, with
the portfolio's risk on the X-axis and the expected return on the Y-axis. This plot
reveals the most desirable portfolios. For example, suppose Portfolio A has an
expected return of 8.5% and a standard deviation of 8%. Further, assume that
Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%.
Portfolio A would be deemed more efficient because it has the same expected
return but lower risk.3
It is possible to draw an upward sloping curve to connect all of the most efficient
portfolios. This curve is called the efficient frontier. Investing in a portfolio
underneath the curve is not desirable because it does not maximize returns for a
given level of risk.3
 
Most portfolios on the efficient frontier contain ETFs from more than one asset
class.

Criticism of Modern Portfolio Theory (MPT)

Perhaps the most serious criticism of MPT is that it evaluates portfolios based on
variance rather than downside risk. Two portfolios that have the same level of
variance and returns are considered equally desirable under modern portfolio
theory. One portfolio may have that variance because of frequent small losses. In
contrast, the other could have that variance because of rare spectacular
declines. Most investors would prefer frequent small losses, which would be
easier to endure. Post-modern portfolio theory (PMPT) attempts to improve on
modern portfolio theory by minimizing downside risk instead of variance.3

Frequently Asked Questions

What is modern portfolio theory?
Modern portfolio theory, introduced by Harry Markowitz in 1952, is a portfolio
construction theory that determines the minimum level of risk for an expected
return. It assumes that investors will favor a portfolio with a lower risk level over a
higher risk level for the same level of return. A central part of modern portfolio
theory is how an individual security impacts the risk and return profile of an entire
portfolio. 
What are the benefits of modern portfolio theory?
Modern portfolio theory can be used as a means to diversify portfolios. By
integrating a diverse set of assets a portfolio can reduce its variance. Another
benefit of modern portfolio theory is that it can be used to reduce volatility. By
 introducing assets in a portfolio that have a negative correlation, such as U.S.
treasuries and small-cap stocks, a portfolio could realize stronger returns rather
than exclusively holding one type of asset within a portfolio. Ultimately, modern
portfolio theory is used to create the most efficient portfolio possible.
What is the importance of the efficient frontier?
The efficient frontier, a cornerstone of modern portfolio theory, shows the set of
portfolios that provide the highest level of return for the lowest level of risk. When
a portfolio falls to the right of the efficient frontier, they possess greater risk
relative to their return. Conversely, when a portfolio falls beneath the slope of the
efficient frontier, they offer a lower level of return relative to risk.

How Is Risk Aversion Measured in Modern

Portfolio Theory (MPT)?
Standard deviation helps investors balance risks and rewards
 FACEBOOK

 TWITTER

 LINKEDIN

By 
INVESTOPEDIA
 
 
Updated Feb 19, 2020
According to modern portfolio theory (MPT), degrees of risk aversion are defined
by the additional marginal return an investor needs to accept more risk. The
required additional marginal return is calculated as the standard deviation of
the return on investment (ROI), otherwise known as the square root of the
variance.

Investors who successfully determine their level of risk aversion can use this
knowledge to build a diversified portfolio that produces a stream of income and
meets their financial goals. Here we discuss modern portfolio theory and a
common tactic investors use to measure risk aversion.
KEY TAKEAWAYS

 Economist Harry Markowitz created modern portfolio theory (MPT) in 1952

as a way to mathematically measure an investor's risk tolerance and
reward expectations.
 By understanding their level of risk aversion, investors can build a
diversified portfolio that meets their financial goals and provides a return
on their investment.
 Standard deviation, which measures how greatly an asset's returns vary
over a period of time, has become the most commonly used gauge to
measure investment risk.
 Risk-averse investors usually want assets with lower standard deviations
because these assets tend to be less volatile with a lower probability for a
major loss.
 Assets with a high standard deviation are considered more volatile,
potentially gaining quickly during rapid market upswings and losing quickly
when markets swing back down.
Risk in the Markets
The general level of risk aversion in the markets can be seen in two ways: by
the risk premium assessed on assets above the risk-free level and by the actual
pricing of risk-free assets, such as United States Treasury bonds. The stronger
the demand for safe instruments, the larger the gap between the rate of return of
risky versus non-risky instruments. Prices for Treasury bonds also increase
during times of strong demand, pushing yields lower.

Modern Portfolio Theory (MPT) and Risk

Economist Harry Markowitz developed modern portfolio theory (MPT) as a way
to mathematically match an investor's risk tolerance and reward expectations to
create the ideal portfolio for that particular investor. When Markowitz introduced
MPT in 1952, its definition of risk, or the standard deviation from the mean,
seemed unorthodox. However, over time, standard deviation has probably
become the most-used gauge for investment risk.

Standard deviation shows how dramatically an asset's returns oscillate over a

period of time. A trading range around the mean price can be created using the
upswings and downswings as measured by standard deviation. Investors use
this information to estimate possible returns for future portfolios.

 
Applying the standard deviation formula will show how much an investment's
price has gone up or down in the past, helping investors evaluate potential future
outcomes for that investment.
Risk-Averse Investors
Risk-averse investors tend to want assets with lower standard deviations. A
lower deviation from the mean suggests the asset's price experiences less
volatility and there is a lower probability for a major loss. Aggressive investors
are comfortable with a higher standard deviation because it suggests higher
returns are also possible.

The reason standard deviation is so widely accepted is it is always expressed in

the same units and proportions as the underlying data. For example, the
standard deviation of height is expressed in feet or inches, while the standard
deviation for stock prices is quoted in terms of dollar price per share. Other risk
metrics develop in accordance with MPT, including beta, R-squared, and
turnover rate.

Possible Flaws With MPT and Risk

Though historically rare, it is possible to have a mutual fund or investment
portfolio with a low standard deviation and still lose money. Losing periods in the
market tend to be steep and short-lived. Low standard deviation assets tend to
lose less in short time periods than others. However, since risk information is
backward-looking, there is no guarantee future returns follow the same pattern.

A larger, trickier issue is that standard deviation is relative in nature. Suppose an

investor looks at two balanced mutual funds. One has a standard deviation of five
units and the other a standard deviation of 10 units. Without other information,
MPT cannot tell the investor if five is low, average, or high. If five is low, 10 might
be average. If five is high, 10 might be extremely high. Investors using standard
deviation should take the time to find the appropriate context, which includes
gaining a better understanding of how investment risk is quantified.